Horses for courses - the various uses for fixed income

Fixed income has the potential to play a more specialist role in portfolio construction than that of a defensive allocation. Here are two ways a fixed income approach can deliver different outcomes. 

Different approaches to fixed income — absolute return and benchmark relative — solve different investment problems for investors. The ability of fixed income to be used in different ways owes much to its diversity as an asset class, and the diversity of approaches employed. This is reflected in a range of factors including the type and quality of issuers, the degree of subordination of the security, the security type, maturity, coupon, individual covenants etc. It’s the combination of these characteristics that drive return and risk outcomes. 

There are some main differences between absolute and benchmark relative fixed income approaches. 

Differentiating absolute return approaches from more traditional approaches

Much of the current commentary focuses on the core defensive properties of traditional fixed income approaches, which emanates primarily from duration. These strategies are generally managed against a benchmark — typically in Australia the Bloomberg Composite 0+Yr — and range from passive (low tracking error) strategies to highly active with a broad investment universe (like core-plus approaches). The common structural characteristic is embedded duration, which makes this the most dominant driver of the total return and risk of these strategies over time. How well the benchmark reflects the defensive characteristics these strategies are trying to emulate is debateable. 

In contrast to duration based/benchmark relative strategies, there is no unique definition of an absolute return fixed income strategy. The broad term describes fixed income approaches that are not benchmark aware and aim to generate returns in excess of cash, bank bills or Libor, utilising assets predominately from within the fixed income universe. While duration may be an alpha source, it is not typically structurally embedded in an absolute return strategy — an important point. 

These strategies can vary considerably, but the common differentiating factors of absolute return fixed income strategies are based around: 

–         Breadth of the opportunity set — is currency in scope, high yield, emerging markets

–         Investment approach — sector rotation, relative value

–         Risk focus — volatility or downside risk focus

–         Use of leverage — in gross and net terms

–         Alpha target — typically +1% to +4%

–         Investment horizon — usually 1 year for risk, but potentially longer for return.

The most fundamental difference between ‘absolute return’ focused strategies and more core, duration focused strategies is the absence of the embedded downside/deflation protection that comes from duration. 

Absolute return strategies utilise the same underlying components, but are focused in their construction on delivering positive returns to investors over relatively short timeframes. They rely more on the skill of the manager to appropriately blend exposures and manage absolute risks. 

Generalised performance characteristics 

It is difficult to make general statements around performance for approaches within the absolute return category given the shorter track record and diversity of investment approaches that are employed. For now, the Morningstar Multi-Strategy Income category appears the best proxy for products employing more of an absolute return approach, and illustrates that the lower reliance on duration does result in a higher correlation to equity assets, although beta to equities remains low. 

Figure 1: Rolling 3 year correlation and beta versus the S&P/ASX 200 index of managers in the Morningstar Australia Bonds and Multi-Strategy Income categories

Source: Morningstar Direct.  Performance of Morningstar Australia Multi-Strategy Income and Bonds – Australia categories are net of fees. 

While correlation with equity assets may be higher, the low beta of absolute return relative to equities does still provide some diversification benefit even during periods of stress as shown in Figure 2 below. 

Figure 2: Performance of Absolute Return Fixed Income approaches during stress environments

Source: Morningstar Direct.  Performance of indices are gross of fees.  Performance of the Morningstar Australia Multi-Strategy Income and Bonds – Australia categories are net of fees. Past performance is not an indicator of future performance

However, as figure 3 highlights, the range of outcomes for absolute return fixed income strategies varies considerably in times of stress, highlighting the heterogeneity of these approaches. 

Figure 3: Range of Performance for fixed income approaches in stress environments

Source: Morningstar Direct.  Chart shows the 5, 25, 50, 75 and 95 percentile range of performance of funds in the Morningstar Australia Multi-Strategy Income and Bonds – Australia categories net of fees. Past performance is not an indicator of future performance.

The factors above offer important context in thinking about their use in portfolios. Absolute return approaches, whether pure absolute return fixed income strategies or short duration alternatives (such as hedge funds, CTAs etc) can play a role at the total portfolio level as primarily lower risk growth/return-seeking strategies. 

While they may also mitigate some of the volatility inherent in equity markets, they should not be viewed as a substitute for the deflationary benefits of duration, and can embed additional risks into the portfolio. Importantly, both more traditional, duration-anchored strategies and absolute return fixed income strategies can co-exist and complement each other in investor portfolios. 

What role do these approaches have in client portfolios? 

While more traditional and absolute return approaches can be used together in client portfolios, their roles are distinct. 

More traditional approaches are designed to provide investors with stable income, a return over time above cash, and a degree of protection against a downturn in risks assets and economic conditions/recession. This is achieved either through passive exposure to the benchmark, or via varying degrees of active management around the benchmark position. In particular, it is expected to produce solid returns — both in absolute and relative to other assets — in periods of economic weakness/recession, when risk assets are struggling and both inflation and monetary conditions are easing. 

Absolute return approaches are aimed at producing relatively stable returns at most stages of the cycle, but notwithstanding the alpha target of these strategies will typically lag equity returns in a bull market (see Figure 3), but also likely lag more traditional approaches (above) during bear markets. Their value comes through the provision of relatively stable income and consistent returns over time. We’d argue an exposure to an absolute return fixed income fund should be funded from a combination of equity, alternative and defensive risk budgets — as opposed to the defensive risk budget for traditional approaches — depending on the nature of the absolute return strategy itself. 

How do we view our fixed income capability in this context? 

We offer investors two products that are consistent with our view that duration based and absolute return strategies both have a role in investor portfolios:

 1.     Schroder Fixed Income Fund

The Schroder Fixed Income Fund is managed as a defensive, core-plus strategy. It is managed with a focus on outperforming the Bloomberg Composite 0+Yr benchmark over the medium term, but importantly we do not view the benchmark as a neutral portfolio. Duration is an important element of the strategy, but targeting the right absolute level of duration is key – as opposed to being exclusively focused on benchmark relativities. The strategy has a broad investment universe and will deviate significantly from benchmark depending on the outlook for the various asset classes. 

It’s viewed as a ‘one-stop’ defensive fixed income solution, designed to provide investors with an actively managed exposure utilising the full scope of the fixed income curve. Its main purpose is to provide clients with a low risk source of return and income, with a key focus on ensuring it is well placed to produce positive returns in periods of equity market weakness. In particular, it is expected to produce solid returns (both in absolute and relative to other assets) in periods of economic weakness/recession, when risk assets are struggling and both inflation and monetary conditions are easing. 

To the extent that we accept that fixed income returns will come under pressure from rising yields, we have adopted a significant short duration position against the benchmark that helps to moderate the impact of rising yields on returns. While this has adversely impacted performance versus benchmark in recent years, more recent performance has benefited materially. 

2.     Schroder Absolute Return Income Fund

The Schroder Absolute Return Income Fund — until recently known as the Schroder Credit Securities Fund — is managed using an absolute return approach. The Schroder Absolute Return Income Fund has a broad investment universe that includes Australian and international corporate and government debt securities, interest rate strategies and currency.  With a focus on managing downside risks, it aims to provide predictable monthly income to investors and outperform the RBA Cash Rate by 2.5% p.a. gross of fees over the medium term. Importantly, this strategy aims to deliver positive returns to investors over rolling 12-month periods. 

This strategy has no fixed or neutral asset allocation. Instead it employs flexible asset allocation across the entire spectrum of fixed income sectors in order to achieve its return and downside risk objectives. This is also consistent with how we utilise fixed income assets in our broader Multi-Asset portfolios. 

The Schroder Absolute Return Income Fund is aimed at producing relatively stable returns at most stages of the cycle, but will lag equity returns in bull market, but likely lag more traditional approaches (like the Schroder Fixed Income Fund) during bear markets. Its value comes through the provision of relatively stable income and consistent returns over time. We’d argue an exposure to the Schroder Absolute Return Income Fund should be funded from a combination of equity, alternative and defensive risk budgets (as opposed to the defensive risk budget for the Schroder Fixed Income Fund). 

A comparison of the Schroder Fixed Income Fund and the Schroder Absolute Return Income Fund is summarised in the following table: 

Figure 4: Comparing the key features of our Fixed Income approaches

 
Source: Morningstar Direct.  Chart shows the 5, 25, 50, 75 and 95 percentile range of performance of funds in the Morningstar Australia Multi-Strategy Income and Bonds – Australia categories net of fees. Past performance is not an indicator of future performance

The factors above offer important context in thinking about their use in portfolios. Absolute return approaches, whether pure absolute return fixed income strategies or short duration alternatives (such as hedge funds, CTA’s etc) can play a role at the total portfolio level as primarily lower risk return seeking strategies.

While they may also mitigate some of the volatility inherent in equity markets, they should not though be viewed as a substitute for the potentially higher diversification benefits of duration. Additionally, these strategies can embed additional risks in to the portfolio. Importantly, both more traditional, duration anchored strategies and absolute return fixed income strategies can co-exist and complement each other in investor portfolios.

What role do these approaches have in client portfolios?

While more traditional and absolute return approaches can be used together in client portfolios, their roles are distinct.

More traditional approaches are designed to provide investors with stable income, a return over time above cash and a degree of protection against a downturn in risks assets and economic conditions or recession. This is achieved either through passive exposure to the benchmark, or via varying degrees of active management around the benchmark position. In particular, it is expected to produce solid returns (both in absolute and relative to other assets) in periods of economic weakness, when risk assets are struggling and both inflation and monetary conditions are easing.

Absolute return approaches are aimed at producing relatively stable returns at most stages of the economic cycle, but notwithstanding the alpha target of these strategies will typically lag equity returns in a bull market (see Figure 3), but also likely lag more traditional duration based approaches during equity bear markets. Their value comes through the provision of relatively stable income and consistent returns over time. We’d argue an exposure to an absolute return fixed income fund should be funded from a combination of equity, alternative and defensive risk budgets (as opposed to the defensive risk budget for traditional approaches), depending on the nature of the absolute return strategy itself.

How do we view our fixed income capability in this context?

We offer investors two products which are consistent with our view that both duration based and absolute return strategies have a role in investor portfolios:

Schroder Fixed Income Fund

The Schroder Fixed Income Fund is managed as a defensive, core-plus strategy. It is managed with a focus on outperforming the Bloomberg Composite 0+Yr benchmark over the medium term, but importantly we do not view the benchmark as a neutral portfolio. Duration is an important element of the strategy, but targeting the right absolute level of duration is key – as opposed to be exclusively focussed on benchmark relativities. The strategy has a broad investment universe, that can include assets outside the benchmark, and will deviate significantly from benchmark depending on the outlook for the various asset classes.

It’s viewed as a “one-stop” defensive fixed income solution, designed to provide investors with an actively managed exposure utilising the full scope of the fixed income universe. Its main purpose is to provide clients with a low risk source of return and income, with a key focus on ensuring it is well placed to produce positive returns during periods of equity market weakness. In particular, it is expected to produce solid returns (both in absolute and relative to other assets) in periods of economic weakness, when risk assets are struggling and both inflation and monetary conditions are easing.

The Schroder Absolute Return Income Fund is managed using an absolute return approach. The Schroder Absolute Return Income Fund has a broad investment universe which includes Australian and international corporate and government debt securities, interest rate strategies and currency.  With a focus on managing downside risks it aims to provide predictable monthly income to investors and outperform the RBA Cash Rate by 2.5% p.a. gross of fees over rolling three-year periods. Importantly, this strategy aims to deliver positive returns to investors over rolling 12 month periods. This strategy has no fixed or neutral asset allocation. Instead it employs flexible asset allocation across the entire spectrum of fixed income sectors in order to achieve its return and downside risk objectives.

The Schroder Absolute Return Income Fund is aimed at producing relatively stable returns at most stages of the cycle, but will lag equity returns in bull market, but likely lag more traditional approaches (like the Schroder Fixed Income Fund) during equity bear markets. Its value comes through the provision of relatively stable income and consistent returns over time. We’d argue an exposure to the Schroder Absolute Return Income Fund should be funded from a combination of equity, alternative and defensive risk budgets (as opposed to the defensive risk budget for the Schroder Fixed Income Fund).