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

Lessons learned in the last decade: returns can only come if we accept risk

For these two reasons, absolute return bond funds have struggled to match the expectations of their investors over the past decade. Most have repeatedly failed to protect them in down markets. And where funds have protected their investors from drawdowns, it has generally come at the expense of generating long-term returns.

In the absence of a crystal ball, the only way to suppress market volatility is to run a lot of short positions to cancel out market movements. But as we have seen, running short positions in the bond market over the long term simply means repeatedly paying out lots of money…

My co-manager, Juan, and I have 20 years’ combined experience in managing absolute return bond funds – including a decade spent running a large absolute return fund together. We learned a lot of valuable lessons in that time. The most important one is this: attempting to deliver positive returns in all market conditions is a noble quest – but it is doomed to fail. It is an unbreakable law that returns can only come if we accept risk.

From ‘absolute return’ to ‘target return’…

Many of the concepts and techniques used by managers of absolute return bond funds remain perfectly valid and fit for purpose. But we accept the limitations of the asset class. Fund managers should be straight with investors as to what can be achieved within the fixed income market – and what can’t.

This is why our new Artemis Target Return Bond Fund is explicitly a ‘target return’ fund, which aims to deliver 2.5% per annum above the Bank of England’s base rate, rather than an ‘absolute return’ fund. We wouldn’t be able to meet that target if the income that is naturally generated by owning bonds goes immediately back out the door through persistent hedging.

We therefore take measured risks across three distinct modules:

• A carry module: the most defensive part of the fund, holding short-dated investment-grade bonds
• A credit module: absolute and relative positions in the investment-grade, high-yield and emerging bond markets
• A rates module: looking for opportunities – whether through curve trades, cross-market trades or inflation positions – in government bond markets

Performance attribution by module

Source: Artemis. As at 31 August 2021

We limit the proportion of the fund that can be invested in any one of these modules, and so limit the fund’s exposure to particular forms of risk (such as interest-rate risk or credit risk).

Yet we accept there will be some modest degree of volatility in the short term. Our experience over the past decade has shown that the short-term bumps will be naturally smoothed out in time.

As the fund’s returns since launch suggest, we think that is a trade-off well worth making – and that the move from ‘absolute return’ to ‘target return’ is one worth taking.

Author Stephen Snowden

Stephen Snowden co-manages the Artemis Target Return Bond Fund alongside Juan Valenzuela. 

1. Data as at 6 October 2021.

FOR PROFESSIONAL AND/OR QUALIFIED INVESTORS ONLY. NOT FOR USE WITH OR BY PRIVATE INVESTORS. CAPITAL AT RISK. All financial investments involve taking risk which means investors may not get back the amount initially invested.

The fund is a sub-fund of Artemis Investment Funds ICVC. For further information, visit www.artemisfunds.com/oeic.

Third parties (including FTSE and Morningstar) whose data may be included in this document do not accept any liability for errors or omissions. For information, visit www.artemisfunds.com/third-party-data.

Any research and analysis in this communication has been obtained by Artemis for its own use. Although this communication is based on sources of information that Artemis believes to be reliable, no guarantee is given as to its accuracy or completeness.

Any forward-looking statements are based on Artemis’ current expectations and projections and are subject to change without notice.