In the aftermath of the global financial crisis, a wave of ‘absolute return’ bond funds was unleashed. At the time, the need seemed obvious. After a 20-year bull market in bonds, and amid huge money printing, the orthodox wisdom was that the bond market was primed for a fall. In January 2010, bond market veteran Bill Gross warned that “UK gilts are resting on a bed of nitro-glycerine”.
As it turned out, however, QE did not create inflation and the 20-year bull market in bonds turned into a 30-year bull market. The most famous bond manager of his era got it famously wrong: 10-year gilt yields fell from 3.9% at the time of his comment to 1.0% today.1
Ten years on, it is time to reflect on what absolute return bond funds have been doing – and delivering for the past decade.
Are there any lessons we should learn? And might there be a better way of doing things?
(To anticipate our conclusion, we think there is: although it shares some techniques and (rightly) sits within the IA Target Absolute Return sector our new fund is explicitly a ‘target return’ fund).
The two problems with shorting bonds
The bond market presents two major challenges to delivering absolute returns:
1: Bonds are expensive to short
The bond market is not a 50/50 bet. If you own a bond you receive income. Therefore it follows logically if you short a bond you will pay out income. That difference between earning income and paying out income skews the likelihood of making money by shorting bonds or other fixed-income securities.
Being short is expensive: to make money being short you need to be right and quick
Probability of profiting from Xover CDS Index
Source: Bloomberg as at 8 September 2020. XoverCDS is an European High Yield Index. Data from September 2006 to September 2020.
Moreover, the more time you spend being short of a fixed-income asset, the more income you must pay out – so the likelihood of profiting from a short position steadily deteriorates over time. The odds are stacked against you. Not only do you need to be right, but you need to be right fairly quickly.
2: Bonds are less volatile than equities
The ability to make money from a classic pair-trade in the bond market is clearly a fraction of what can be achieved in the equity market.
Source: ICE BofA, Bloomberg as at 31 December 2019. Figures show 12 month total return
Absolute return bond funds prosper best in volatile markets. The greater the volatility, the greater the dislocations in markets, and therefore the greater the opportunity to put on positions that will profit from the longer run normalisation of markets.
The following chart plots the evolution of the Merrill Lynch Options Volatility Estimate (the MOVE index – a measure of uncertainty about interest rates) over time. It shows us that volatility was high when many absolute bond funds were being designed and launched in 2008-09. However, that volatility did not persist; it has fallen. That has made it increasingly hard to generate returns.
Falling volatility in the bond market has made it increasingly difficult to for absolute return bond funds to generate returns
Source: Bloomberg. As at 6 Oct 21